Iron ore may outperform copper on price-ratio analysis: Clyde Russell

SummaryCopper and iron ore demand and prices both stand to rise, given the improvement in both of China's purchasing managers' surveys, but the steel-making ingredient may have scope for bigger gains.

Copper and iron ore demand and prices both stand to rise, given the improvement in both of China's purchasing managers' surveys, but the steel-making ingredient may have scope for bigger gains.

While there are fundamental reasons why iron ore may outperform copper, perhaps the most convincing analysis is looking at the price ratio between the two.

Benchmark three-month Shanghai Futures Exchange copper futures, converted to U.S. dollars, currently trade about 80 times the price per tonne of spot iron ore.

While this is down from the 101 times recorded on Sept. 4, it's still near the highest since iron ore swaps started trading in Singapore in 2008.

Looking at the ratio between the two over the past four years, there have been about three periods when the ratio has reached levels above 80 for a sustained period before the current occurrence.

In March 2009, the ratio was about 83 times, in September of the same year it was above 95 and in October last year it was 81.

Each time the ratio has reached these levels, it has subsequently moved lower.

For example, by mid-August 2009 it was down to 68, by April 2010 it fell to 47 and in November 2011 it was 59.

What is common to the three examples above is that every time the ratio was high, it moved lower by iron ore rallying harder than copper.

Likewise, every time the ratio widened again it was because iron ore fell faster than copper.

In the current situation the ratio has narrowed from the 101 seen in September, but given it's still as high as 80, there would appear to be scope for it narrow even further.

This analysis also shows that the iron ore market appears to be more volatile and tends to overshoot to both the top and the bottom of each pricing cycle.

It's apparent now that iron ore's third-quarter slump to a low of $86.70 a tonne, the weakest price in three years, was worse than justified even by the slowing of growth in major buyer China.

At the time iron ore was crashing, Shanghai copper was relatively stable in dollar terms, and iron ore's subsequent rally to current levels around $115 a tonne still leaves plenty of room for the ratio to the copper price to narrow further.

It would take an iron ore surge to above $150 a tonne to bring the ratio back to 60 times, a level historically associated with times when iron ore starts to once again underperform copper.

It's also worth pointing out that just because the ratio has narrowed in the past due to iron ore rallying, this doesn't mean this will necessarily happen again.

It could be that this time copper declines while iron ore remains relatively stable, and certainly there are a few reasons to believe the red metal may struggle.

Rising mine supply in 2013, anecdotes of elevated levels of unreported stockpiles in China and an uneven economic recovery may weigh on copper.

The official China Purchasing Managers' Index, which rose to a seven-month high of 50.6 in November, also shows growth is being led by the state sector, with large enterprises undertaking infrastructure spending.

This is probably more supportive of iron ore, given that building infrastructure such as railways tends to be more steel-than copper-intensive.

In the present environment of a modest recovery in China, being led by state capital expenditure, it seems that iron ore is a better bet than copper.

(Clyde Russell is a Reuters market analyst. The views expressed are his own)